Boutique staying true to its roots

Peter Wilby chose Stone Harbor, a beach town on the east coast of the US, as a location to negotiate a deal to spin off a team of some 65 professionals including 27 investment specialists from the entity created by Legg Mason’s acquisition of Citigroup Asset Management last year.

The aim, he says, was to create an alpha-generating fixed income boutique, or ‘credit specialty shop’, that would operate in the style of the fixed income unit created by Salomon Brothers Asset Management in 1989 and acquired by Citigroup in 1997. To mark the deal, Wilby and his fellow partners decided to call the new enterprise Stone Harbor Investment Partners.

Stone Harbor, which is based in New York, now has $8.7bn (€6.6bn) in assets, over 30 institutional clients and has just opened an office in London. It has no debt and is 100% owned by its 65 partners, most of whom moved with Wilby from Citigroup. Ownership of the firm is well diversified with no one person having control.

“We transported the senior team out. Except for a couple of technology hires and 1 new emerging markets currency and derivatives specialist everyone came out of Citigroup. This is something you couldn’t do ordinarily”, says Wilby.

The origins of this unusual spin-off can be found in Salomon Bothers decision to enter the investment management business in 1989. This transformed a small tax-exempt US private account business, intended principally for Salomon Brothers partners, into a full-blown asset management business.

In 1989 Salomon hired Peter Wilby as its first fixed income manager. This was a chance to create a start up business under the umbrella of an investment bank “We were a very small boutique company. We were owned by Salomon Brothers but they left us completely alone.”

“We started with next to nothing but were quickly able to grow from $400m in 1989 to $22bn by 1997. After seven years with Salomon we had a very strong reputation and track record in specialty fixed income assets. Our emerging market track record goes back to 1990.”

In 1997 Salomon was sold to Travelers, the insurer, which eight months later merged with Citibank to create Citigroup. The merger created the world’s largest financial institution with 300,000 employees.

This provided some benefits to the fixed income operation, says Wilby. “It brought a massive amount of distribution. Our fixed income group grew from $22bn to $200bn in assets, although the sale of Travelers Property and Casualty company took out around $35bn to $44bn.

“So from the point of view of wanting to be a size market player, affiliation with Citigroup worked. But at some point in our tenure we realised that we had to strike out on our own. It was something we had in mind for a significant number of years. The Legg Mason/Citigroup transaction gave us an opportunity to do this.”

The trigger was Legg Mason’s own fixed income group, Pasadena-based Western Asset Management. Legg Mason planned to integrate Citigroup’s ex-Salomon team into this operation.

The result would have been a clash of cultures, he says. One problem was geography. “We were a New York team and we weren’t going to move to move to Pasadena,” says Wilby,. More important, absorption would have meant losing the distinctive approach of the ex-Salomon team. “We had a very good reputation and we said we’re not going to change the way we do things. Western Asset Management is both a high performance and high integrity business and shouldn’t of course do anything to change the way they do things either” he says.

Yet the Citigroup and Legg Mason needed Wilby’s team to help with the re-distribution and integration of the new entity’s assets. Under an arrangement Wilby and his team agreed to help Legg Mason integrate the assets, in return for a deal which would enable them to spin-off the Stone Harbor part of the fixed income operation.

“The deal was that we would stay till the end of the fiscal year 2006. Our obligation was to help transition a chunk of the retail and international business to them,” says Wilby.

“In exchange for that we were allowed to solicit a certain amount of assets that they agreed were not likely to stay anyway.”

Almost every pension client that Wilby and his investment team were permitted to approach agreed to move. “Only one client surprised us in not coming. But just about everyone else in our speciality assets who we were allowed to solicit came. And there were other accounts that would have liked to have come but we were not allowed to solicit.”

What makes this an unusual start-up, says Wilby is the client base it has been able to carry over from Citigroup. “We have very close relationships with our clients having worked with some of them for the past 15 years. They are not going to be sold and told who’s going to manage their money.”

Stone Harbor ended up with 32 clients and 38 separate mandates. These included three of some of the largest funds in Europe and some of the largest corporate and public US pension funds.

“We currently have around $8.7 bn in assets, which is over 90% of what we were allowed to solicit,” says Wilby. “This is all institutional money, managed for pension investors, some insurance companies and some sub-advisory arrangements. Three quarters of the assets are inside the US. The rest are clients in Europe, and a small number of clients in Asia.”

To help set up the infrastructure of the new company, Wilby recruited Thomas Brock, a former chief executive officer and chairman of Salomon Brothers Asset Management and more recently professor of investment management at Columbia University Graduate School of Business in New York City.

ilby says the main task this year will be to reassure clients that Stone Harbor will continue to provide the fixed income expertise it provided at Salomon and then at Citigroup.

His team are perhaps best known for their emerging market debt and high yield skills. “At one time we were probably the second largest, maybe the largest, pension fund manager in the emerging market debt market. In emerging markets debt we have a track record that goes back to 1990 where we’ve returned over 18% annualized for 16 years with only two negative years.

“We also have a strong high yield corporate record, both in the US and globally. Combining those two - emerging markets and high yield - has been one of our strengths.”

These are managed with different styles to produce uncorrelated alphas, Wilby says. “The emerging markets style has a bit of a value tilt, but it is also a momentum style, so it tends to do very well in up markers. The high yield style is very value driven , so it tends to do best when the high yield market is coming apart.

“We also have a 13 year record doing enhanced core with very high alpha. This is more aggressive than core plus and the point is to have no more volatility than the benchmark but a significantly higher return.”

The current focus is on total return investing. “We want to roll up these strategies and take them forward into total return styles, where we aim for LIBOR plus 200 to 300,” he says.

Next year, Stone Harbor will turn its attention to absolute return strategies. “That’s something well focus on next year and beyond. But it’s not our objective to be a pure hedge fund manager. We want to be a traditional manager who rolls some of these skills into alternatives styles.”

Alternatives are often capacity-constrained, he says, and one of the advantages of being a boutique is that it can respond to capacity issues in a way that a large asset manager cannot.

‘High yield is an absolutely capacity constrained asset class, and one of my fears is that we have some large pension plans who can still use up capacity rather quickly.

“We run $3bn in high yield bonds right now. Before we had a lot more than that but would prefer to be more nimble in this assets class. We will close high yield with $6bn assets and that’s fine with us. We’re very cash flow positive and we’d rather keep our performance and our reputation.”

Wilby takes the same deliberate approach to geographical expansion Stone Harbor has opened a London office for two portfolio managers and two client relation managers working on non US clients. An office in Asia in a couple of years is a likely next step. But the business is firmly rooted in New York, and will likely remain so.

Stone Harbor’s success, he suggests, will depend on never losing sight of why he and his team sought to manage money in the form an independent boutique structure. “We have a very clear style of managing money that we want to keep intact. Of course we will build on our strengths, stretch ourselves a bit by being innovative but not to the extent where we step out of the core competencies that we’ve developed together over 15 years”